A two-sector model of the effects of wage compression on unemployment and industry distribution of employment

Abstract

In the dynamic model presented in the paper manufacturing and service firms coexist. They use labor inputs provided by households which buy both the manufactured good and the service. The latter may differ in its quality depending on the effort level of the firms’ employees. Service firms must invest in reputation for quality. As the long-term equilibrium emerging in a competitive framework is characterized by unemployment, the imposition of a binding wage floor lowers employment in the service sector without affecting the employment level of the manufacturing sector: the wage differentials between the two sectors shrink and the quality level of the service improves, but unemployment increases. As the competitive solution leads the economy to a full-employment steady state, a binding but relatively low minimum wage may bring about a more equalitarian income distribution and upgrade the quality content of jobs in the service sector, without creating unemployment.